Timing is critical, says Mark Plewes, Head of Pensions Technical at WBR Group, when it comes to a client who has scheme-specific protected lump sum rights and multiple pension arrangements.
Where a member has benefits in more than one money purchase scheme, planning the timing of pension commencement lump sum (PCLS) payments is crucial when that scheme member has scheme specific lump sum protection in one or more schemes.
Following the abolition of the Lifetime Allowance (LTA), tax-free pension lump sums are constrained by two allowances, the Lump Sum Allowance (LSA) and the Lump Sum and Death Benefit Allowance (LSDBA).
Where a member holds scheme specific lump sum protection in one or more schemes, getting the sequence wrong can lead to part of a lump sum being taxed at the member’s marginal rate.
Reviewing available allowances and considering the timing of each crystallisation is therefore crucial to preserve as much of these enhanced tax-free rights as possible.
Understanding the LSA and LSDBA limits
The LSA caps the total PCLS and other relevant lump sums, such as a standalone lump sum and the tax-free portion of an uncrystallised funds lump sum, that an individual can take tax-free in their lifetime. The standard allowance for most people without protection is £268,275.
The LSDBA, for which the standard allowance is £1,073,100, is a broader limit covering all tax-free lump sum payments including relevant lump sums taken by the member in their lifetime and certain lump sum death benefits paid to their beneficiaries.
In practice, any PCLS taken by a member uses up an equal amount of both allowances in most cases. In very simple terms, if a PCLS exceeds the amount of either allowance remaining for the member, the excess is taxed as income at the member’s marginal rate.
Scheme-specific lump sum protection arises when a member had rights to more than 25% of their fund as tax-free cash on 5 April 2006 (A-Day). This is often found in older occupational schemes and remains relatively common in established Small Self-Administered Schemes (SSAS) where members had accrued rights prior to 2006.
Unlike those members with formal lifetime allowance protections, members with only scheme specific protection do not get a higher LSA or LSDBA beyond the standard figures.
When the LTA was abolished and the LSA and LSDBA were introduced, HMRC tweaked how these allowances are used in such cases to avoid penalising those members’ extra PCLS rights.
Where a PCLS is paid with scheme specific lump sum protection, only 25% of the fund’s value being crystallised and not the full PCLS amount paid counts against the LSA, while the full PCLS amount paid counts against the LSDBA.
This means PCLS with scheme specific lump sum protection can often be paid even if it exceeds the member’s remaining LSA, provided enough LSDBA is still available. However, any portion of a PCLS above the member’s available LSDBA will be taxable at their marginal rate.
Effectively, the LSDBA becomes the ultimate cap on tax-free lump sum payouts for these individuals when crystallising benefits under scheme specific lump sum protection.
Timing of crystallisations – why it’s critical
The sequence of crystallisation events matters greatly when dealing with a client who has scheme-specific protected lump sum rights and multiple pension arrangements.
Using up allowances on one pension can constrain PCLS from another. A common pitfall is crystallising a protected lump sum scheme too early, which can inadvertently drain the LSA that could have allowed more tax-free cash from other schemes.
By contrast, crystallising the protected lump sum later, after taking standard PCLS from other pots can maximise total tax-free cash.
The lesson is simple, model out different scenarios with their associated allowance usage and outcomes and carefully plan which pension to crystallise first.
This is especially true for clients with large pension funds and special lump sum entitlements.
Beyond the order in which crystallisations are made there are other key issues to consider. The individual must become entitled to all of their pension rights under the protected scheme on the same date.
Phasing or partial crystallisation of benefits with scheme specific lump sum protection will therefore forfeit the protection and is a risk to avoid.
Collating full details of any previous benefit crystallisations both before and after April 2024 is also a must to accurately calculate remaining LSA and LSDBA.
With considered planning around the order of crystallisations, as well as being mindful of LSA and LSDBA limits, advice professionals can help clients maximise their tax-free cash entitlement and avoid unnecessary tax charges.
A disciplined approach in such circumstances will ensure that scheme specific lump sum rights are fully utilised for the client’s benefit without unwelcome tax surprises.
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